Oil Majors Set for Big Profits in 2018, But Capex to Rise Only Slightly

Oil prices are trading at multi-year highs and the market balances continue to tighten, creating a sense of confidence in the oil industry that has largely been absent since the downturn began in 2014. Oil majors have cut costs, improved drilling techniques, and shelved projects that no longer made sense. As a result of these efforts, most oil companies have lowered the price at which their operations breakeven, and with oil prices up significantly over the past few months, the industry is on sounder footing than at any point in the last few years.

Oil prices are trading at multi-year highs and the market balances continue to tighten, creating a sense of confidence in the oil industry that has largely been absent since the downturn began in 2014.

However, a stronger financial position among major oil companies will not necessarily lead to higher spending. A long list of firms will reveal their financials in the next few weeks, along with spending plans for 2018 and beyond, but analysts expect only modest increases in capital expenditures. Instead, improving cash flow will likely translate into share buybacks, higher dividends, and reduction of debt.

Improving cash flow

In the third quarter of 2017, the oil majors posted some of their best figures in years. ExxonMobil took in $4 billion for the quarter, up 50 percent from a year before. Chevron’s earnings also rose by 50 percent to $2 billion. Nearly all of the largest oil companies posted similar improvements in earnings. The fourth quarter results will yield more of the same for the majors.

There are several reasons why the industry is rebounding. Breakeven prices continue to fall, oil prices have moved up, and spending programs have remained in check. Moreover, as large-scale projects have come online—massive LNG projects in the case of Shell and Chevron, for instance—spending requirements have also declined. And unlike their smaller shale peers, the integrated oil majors have diversified assets pipelines, refining, and petrochemicals, all of which yielded benefits even when oil prices fell.

Rising oil prices mean 2018 has the potential to be one of the best years ever for Big Oil.

Rising oil prices mean 2018 has the potential to be one of the best years ever for Big Oil. According to BMO Capital Markets, and cited by Reuters, oil majors will generate more cash this year with oil at $60 per barrel than they did back in 2011 when prices averaged $112 per barrel.

A more cautious approach

A sharp improvement in companies’ financials does not necessarily mean a return to the days of aggressive spending. After several years of negative results, shareholders are demanding to see some of the benefits of rising prices. Last year, BP announced a return to its share buyback program after a several-year hiatus. In November, Shell canceled its scrip dividend program and promised to once again pay shareholders in cash. Most analysts see that trend continuing this year, as shareholders want compensation after several years of dilution. “With the scrips coming off and share buybacks to commence, we expect an uplift in shareholder distributions by around $24 billion, led by Shell,” Brendan Warn, an analyst at BMO, told Reuters.

Moreover, further price gains are by no means assured, as the current surge in U.S. shale supply could reverse prices once again. After several false price rallies since 2015, the oil industry—aided by pressure from shareholders—is showing more caution this time around.

“The companies will need to demonstrate over time that lower capital spending can be sustained and that their dividends will remain fully covered,” Jonathan Waghorn, energy fund manager at Guinness Asset Management, told Reuters. “We are cautiously optimistic on their ability to do this, given the dramatic cost reductions in the industry.”

The oil majors are expected to post $80 billion in organic free cash flow in 2018.

The oil majors are expected to post $80 billion in organic free cash flow in 2018, according to BMO Capital Markets, much of which will find its way back to shareholders. “The best use of excess fund flow now would be a little further debt reduction for those companies that need it, and then an end to the scrip dividend,” Darren Sissons, partner and portfolio manager at Toronto-based Campbell, Lee & Ross Investment Management, said in a Reuters interview.

The shale industry faces similar dynamics, although with weaker balance sheets. Shale drillers, for the most part, have yet to demonstrate profitability on a sustained basis. For years, shale E&Ps racked up debt as they drilled at a fast pace, replacing old wells with new ones. Shale drilling promised that rapid growth would eventually lead to huge profits, but positive cash flow has proven to be elusive. Companies touted exceptionally low breakeven prices, but those figures often overlooked other costs unrelated to drilling, such as purchasing leases, buying acreage, the cost of finance, as well as other administrative expenses. Since 2010, the shale industry has spent $265 billion more than it generated from operations, according to the Wall Street Journal.

Shale investors are now demanding a focus on profits rather than simply growth. That has led to changes in executive compensation, with some firms scrapping CEO rewards that have been linked to drilling metrics. The good news for shale E&Ps is that they are also benefitting from the same trends that the oil majors are enjoying: lower production costs, efficiency gains, and rising oil prices, all of which could make U.S. shale profitable in 2018, essentially for the first time.

The danger for the shale industry is that with WTI now trading in the mid-$60s, E&Ps may be lured back into action and not move forward with spending restraint that investors want.

Instead of putting that money back into new drilling, as was typical in the past, investors are pressing shale companies to pay down debt and recycle cash back to shareholders in the form of dividends and buybacks. So far, early signs point to this trend playing out. A survey of over 20 shale companies by Jeffries, and cited by the Wall Street Journal, found that spending is expected to rise by an average of 8 percent this year, after a sharp 55 percent increase in 2017. The danger for the shale industry is that with WTI now trading in the mid-$60s, E&Ps may be lured back into action and not move forward with spending restraint that investors want.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.